Jumping into June


“Then followed that beautiful season… Summer….” – Henry Wadsworth Longfellow

A good way to characterize the recent advance in the asset markets (prices for collectibles such as fine art objects and professional sports teams are also booming) is to note that there is investor euphoria, but not economic euphoria. In the past, that has led to very bad endings for asset prices. To which any self-respecting trader would reply, “sure, but prices went up some more first.” True enough.

Sometimes the economy casts a glow over stock prices, as it did through most of the 1980s and 1990s. At other times, the stock market casts a glow over the economy, as it did in 2007 and 1999, and again today. The tape makes the news.

In 2006 and 2007, real GDP slipped from 3.4% in 2005 to 2.7% and 1.8% respectively. The S&P 500 rose 15.6% in 2006 and 5.5% in 2007, notwithstanding the growth decline. In 2012 and 2013, real GDP went from 2.8% to 1.9%, an eerie echo; the S&P rose 15.9% in 2012 and 32% in 2013. The index is now up 5% in 2013, despite profit growth of only 2% in the first quarter for the index companies, and a quarterly decline in profits for the corporate sector overall. Long-term investors take note and start ringing the tocsin, while shorter-term folk note the irrelevance of GDP to making bets in the stock market.

The economy doesn’t feel great to the average worker, so they not only do not feel the urge to add money to the stock market, they look at the increases with disbelief and even disdain. The short-term traders are not looking at profits or the economy, but at the prospect of more central bank liquidity adding more money to the game of buying the same objects, be they equities or other volatile collectibles.

CNBC has long been the televised face of the stock market for most, but its ratings have suffered in recent times. There are differing explanations as to why – e.g., the programming is too conservative, the programming is too liberal – but one reason that strikes me these days as hurting the network is its relentless Panglossian defense of stock market ascents even as the real economy sputters. If I had played a drinking game any day last week in which one were required to imbibe each time a CNBC newsreader (or online post) said “record high,” I’d have been legally dead before the market closed that day. I heard “Goldilocks” all day Friday without the slightest touch of irony.

My guess is that the people at CBNC are trying to put a happy enough face on the stock market to get more people to watch, but if that is the case, I think that they are only succeeding in convincing more people that the stock market is for nuts and gamblers. I read two articles in the last week that add to my own concern about the market’s anchor to its traditional ground of corporate profits and the outlook for the same.

One article appeared on the BloombergView website, regarding dark pools (off-exchange trading venues) and high-frequency trading; the other in the Financial Analysts Journal (you need to be a subscriber for the full article, but you can get a summary here). The gist of them here is that the self-reinforcing aspect of modern electronic trading may be greater than I have appreciated, even though I have periodically carped about the problem.

The S&P 500 may be up 5% in 2014, but 80% of that move has come in the last three weeks. I previously wrote that both short-squeezing (short positions were at a multi-year high by mid-May) and then anticipation of the European Central Bank (ECB) meeting were largely responsible, but it seems to me that the very low volume accompanying the steep rally is a signal that the move is also being driven by trading strategies that attempt to sniff out trends (and other programs sniffing out trends). In so doing, they amplify the trend that they are chasing. Something like this in human form has always gone on, but may be much more meaningful now against a backdrop of lower participation and an economy that while not contracting, isn’t especially inviting either.

In short, as prices are more and more dominated by algorithms instead of earnings and investment flows, they drive off a large segment of the investing population and in turn become more and more dominated by their electronic masters. It’s another self-reinforcing circle. The exchanges seem too beholden to volume-generators to care about how it happens or who does it, while the Bloomberg piece highlights how difficult it is for the SEC and its modest budget – political as well as financial – to do anything about it.

There is also a disconnect going on in liquidity perception. The Federal Reserve is actually slowing its liquidity additions and intends to be out of the game entirely by the end of the year. The ECB is not actually adding new money to the system, the way the Fed did with its QE, but is trying to push existing money into lending more. It may do asset-backed purchases (ABS) if circumstances warrant (and a eurozone market for them develops), but for the moment it is not doing anything of the sort. If the bank can get the euro to weaken, I can assure you that buying bonds will not be on the agenda, though it may have trouble with the former goal – ECB President Mario Draghi’s assurances have also fanned the fad for buying EU-member sovereign bonds, and that will work against his not-so-covert goal of weakening the currency.

By the end of the week, I was certainly seeing signs of investor euphoria that the central banks are guaranteeing equity gains. They aren’t, though I admit that the perception may outweigh the reality (again) in the near term. As it stands today, the S&P is severely overbought and you can expect consolidation at minimum in the next few days. If traders can shake that off and keep pushing towards S&P 2000 by the Fed meeting on the 18th of this month, the already-alarmed bank is apt to dump a very cold bucket of water on the proceedings.

That’s one black swan to consider (the search for them seems to be quite in vogue at the moment). Another is the electronic phenomenon I referred to earlier. Though the exchanges have put in safeguards against another 1987-style crash (essentially they simply shut down before the damage can get that great), it would appear that vulnerability to another flash-crash type event, whether accidental or deliberate, as a one-off or as a series of events, has grown. Vulnerability is not the same as action, so I make no dire predictions, but note that vulnerability also increases with altitude, and when it comes to valuation, prices have jumped too darn high. Crashes come from a height.

The Economic Beat

The U.S. report of the week was the jobs report, as is custom. The initial estimate for non-farm payroll additions was 217,000, seasonally adjusted, beating both the “official” consensus estimate of 215,000 and the ADP payroll number two days earlier, which had reported a May total of 179,000 and a downward revision to its April count (now 215K). The whisper number for the Bureau of Labor Services (BLS) survey came down in the wake of the ADP numbers, allowing the market to rally.

What was striking about the BLS report for May was its constancy. The year-over-year change in establishment payrolls (unadjusted) was 1.75%, compared to 1.74% for April. The January-to-May change in payrolls was 2.8%, the same as last year – it’s been 2.7%-2.8% for the last five years. Through the first five months, the payroll count is up 0.67% versus 0.63% last year and 0.72% the year before. The differences are tiny and well within any margin of error – it’s been a remarkably stable trend.

Unfortunately, other aspects have been similarly stable. Weekly hours are the same as a year ago, the annual growth in average weekly earnings is still stuck at 2%. The year-on-year increase in household jobs was under 2mm in May, compared to 2.4mm for the establishment survey, indicating the persistence of people having more than one-part job: there is still a consistently large amount of slack in the labor force. New jobs tend to be bottom-feeding: 25% of the payroll addition was made up of the “health care and social assistance category.” Combine that with leisure-hospitality and temp jobs and you have three-quarters (!) of the total. I just can’t call that robust without having some hidden motive.

The ISM surveys lent weather-rebound elan to the rally. April wasn’t much of a cause for celebration in the regions hit worst by cold winter weather – the warming was gradual and in fits and starts. I still ran my expensive oil furnace through much of the earlier month, and even a couple of times in May, something new to my experience. But if the latter month was not quite glorious, it was definitely a big improvement. As I have written before, it’s delivering the weather bounce that April failed to bring (in this week’s Seeking Alpha column, I called May “the new April”).

There was some confusion with the ISM manufacturing survey – the initial release of 53.2 for May was below estimates, but then the number was released twice in the ensuing minutes, ending up, at 55.4, just shy of consensus for 55.5. At that point, though, the relief factor outweighed the miss and stocks rallied anyway. Later in the week the ISM services report reported 56.3 for May, beating consensus by – wait for it – a full point. More rally.

I’ll say it for the nth time – the ISM surveys are diffusion measures that measure breadth, not depth. It can be seen within the reports themselves, which both had 17 out of 18 sectors reporting overall growth. New orders diffusion growth in manufacturing actually deteriorated, though seasonal adjustments boosted the headline result to an improvement. I’ve studied the ISM data at length – they are not reliable leading indicators of either the economy or the stock market. They are coincident measures, where monthly variations of a point or two are significant only to stock and bond traders and their black boxes, signifying virtually nothing about the economy.

The Econoday website reported that the services report showed “Growth in the bulk of the nation’s economy is very strong,” but I disagree completely with that assessment. What it did show was that growth rebounded across most sectors; it did not say anything about how strong that rebound was. I would also add that I suspect both readings of getting a little extra seasonal adjustment boost from an actual April-May weather change being at odds with the longer-term statistical trend – and then further add that it doesn’t matter anyway: the extra point or two (in either direction) being practically meaningless.

Factory orders beat consensus with an April report of 0.7% versus 0.5% estimated. The durable goods portion was revised downward from 0.8% to 0.6%; business investment spending remained unchanged with a decline of 0.4%. Mortgage-purchase data fell back during the previous week; with a year-on-year decline of 15%, the housing sector remains subdued, to say the least.

Construction spending in April was reported at +0.2%, with a revision to March from 0.2% to 0.6%. The monthly data is subject to such large revisions that I hate to draw any conclusions from it. The Fed’s Beige Book reported “modest to moderate” growth in all twelve districts in May, about what you would have guessed without talking to any of the regional banks, but frequently treated by newsreaders as some sort of astounding development. The trade deficit widened in both March and April, putting downward pressure on GDP readings for the first and second quarters.

Next week will feature the May retail spending report on Thursday, which should be upwards of the 0.7% consensus I am currently seeing. Chain-store reports showed a definite warm-weather rebound, both in their data and in their commentary, while auto sales had a very good month, boosted by easy and plentiful credit. It should also represent the apogee of the weather-rebound effect in exaggerated predictions by Wall Street boosters.

The sales report will be the highlight of what should otherwise be a quiet week on the economic calendar. Other reports of varying interest include the small business optimism index and the labor turnover (JOLTS) survey on Tuesday, followed by the start of May price data, with import-export prices on Thursday and producer prices on Friday. Friday morning brings retail sales and industrial production data from China, though these should be taken with a very large grain of salt.

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